ET Phone Home

ET Phone Home…There have been many jokes, quips and witticisms about the unfortunately named extraterritoriality (ET) issues related to OTC derivatives rules in the US.

Some have even been funny.

But not everyone is smiling about ET, as this story by Dow Jones/The Wall Street Journal points out:

“European Union and U.K. regulators urged the U.S. to delay new rules for swaps contracts and reconsider how they apply to foreign banks and transactions.  The complaints add to a chorus of concerns, including from Japanese, French and Swiss regulators, that the U.S. is overstepping its jurisdiction.”

What, exactly, is the beef?

According to a letter from the European Commission that’s quoted in the article, the US rules could “lead to duplication of laws and to potentially irreconcilable conflicts of laws for market operators.”

This is a theme we have sounded before.  It’s also one that policymakers from Asia are voicing.  Earlier this week, five regulators from three Asia-Pacific jurisdictions (Hong Kong, Singapore and Australia) jointly signed a letter to the CFTC voicing their concerns.  As their letter states:

“…we are concerned that some of the proposed requirements as they currently stand may have significant effects on financial markets and institutions outside of the US. We believe a failure to address these concerns could have unintended consequences, including increasing market fragmentation and, potentially, systemic risk in these markets, as well as unduly increasing the compliance burden on industry and regulators.”

Is there a solution in sight?

Perhaps.  As Hong Kong’s Secretary for Finance Services and The Treasury separately wrote to US policymakers:

“…we call for greater coordination internationally on implementation of OTC regulations, particularly those with cross-border implications.  We hope the CFTC, SEC and the US Treasury will defer the application of the US rules and regulations over non-US persons and work with the international community on a coordinated framework on regulatory cooperation in cross-border OTC transactions.  We also hope the US authorities would provide greater clarity to the Proposed Guidance and to recognize the OTC derivatives regulatory regimes of overseas jurisdictions on the basis of international standard.”

The lines are open.  Regulators are standing by.

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Not So Fast, Let’s Stop and Think

Today’s New York Times contains an interesting story — “Strong and Fast Markets, But No Time to Think” — that reflects on the trading glitches that roiled equities markets on Wednesday.

The article discusses the evolution in securities trading over the past quarter century. It states that this change has largely been positive, but also points out potential pitfalls.

Chief among them: “…the improved markets also are more prone to disaster.” Why? Partly because “Market makers have been largely replaced by high-frequency traders who use computers that can react to orders in nanoseconds.”

As evidenced by yesterday’s problems, or those related to the “flash crash” in May 2010, no trading system is perfect.

There is an interesting parallel here to the OTC derivatives markets. Current policy proposals might significantly change their structure and the role that market makers play in them. These proposals could transform OTC derivatives from an institutional market with low trading volumes and large notional amounts per trade to a quasi-retail market with vastly higher trading volumes and small notional amounts per trade.

We’re not sure what purpose this would serve. Given the price competition and the extremely tight spreads in the most liquid part of the OTC derivatives markets, the impact on trading costs would appear to be minimal.

It is true that smaller end-users might benefit from lower costs, but any benefit here is likely to be more than offset by the higher costs that larger end-users might incur.

Simply stated, there is very little evidence to support the idea that the proposed changes in the structure of OTC derivatives trading would benefit market participants.

As a result, we do not think these market structure changes were the intent of the G-20 Communique issued in Pittsburgh in 2009 that formed the basis of the legislative proposals that have since advanced in key jurisdictions.

To the contrary, we believe that the overriding goal of post-crisis public policy initiatives is to build a stronger financial system and reduce systemic risk.

Efforts to increase central clearing of trades and to improve regulatory transparency do just that, which is why we and market participants are on board with and helping to drive progress in these areas.

Efforts to change how one market works should clearly be backed up by substantial evidence that those changes will bring improvement. For OTC derivatives, that evidence has been a slow train coming.